Things become serious

Financial markets worlwide are still dominated in toto by the worsening European crisis. Developments out of the Continent could hardly be worse. Spanish and Italian spreads reached niew highs and sovereign credits that had so far been considered safe started to perform badly. A massive gap has opened up between the sovereign bond markets and the currency markets. Whereas the latter are pricing in an increasing likelihood of a disorderly Euro break up, the common currency continues to hold up above the 1.35 level. Meanwhile, moderately positive macroeconomic news out of the United States continue to be more or less ignored by FX markets, rightly in our view. As an anonymous trader put it last week, everyone is assumming someone is going to do something about the European disaster, but what if everyone is wrong?

At the risk of sounding like a broken record, we reiterate our view: in the absence of an explicit guarantee of European sovereign debt from the ECB, no solution to the Euro crisis is likely to work for very long, and we continue to be surprised by the lofty levels at which the Euro is trading against other G10 currencies.

GBP

The UK is mercifully being spared the sovereign liquidity shock engulfing the Eurozone, but financial and trade linkages with the Continent are still very strong. Strategists are following the lead from the Bank of Engalnd and are revising down their growth expectations. Growth through the first half of 2012 is now expected to be essentially flat. Not surprisingly, Sterling sold off heavily against the dollar but traded in a very narrow range against the common currency.

EUR

The news out of the Eurozone turned worse by the week. Italian and Spanish spreads hit new records among diminshing liquidity. In fact, it is increasingly apparent that the sporadic interventions of the ECB constitute just about the only buying flow in those markets. Further, in the middle of last week heretofore unshakable AAA credits like Finland and the Netherlands joined in the selloff, and their spreads blew out nearly 40 bp before drifting tighter on Thursday. French spreads are now 200 bp, where Italy was four short months ago. The Eurozone financial system cannot work if the only safe debt is that of Germany; that much is clear. However, a recalcitrant Draghi made it clear in a harsh speech that the ECB is no closer to taking a leading role in the crisis. We are afraid that things will have to get worse, perhaps much worse, before the Bundesbank sadomonetarists in control of the ECB come to their senses. Meanwhile, we find it hard to believe that the Euro can keep its current high levels under the circumstances, and maintain our very bearish view of the common currency.

USD

Macroeconomic news out of the United States continued to show slow but steady improvment last week. Weekly jobless claims, perhaps the most accurate high frequency indicator, dropped again and the 4-week average dropped below the 400,000 level for the first time in many months. Housing construction is giving some signs of life. Though we still await confirmation of this tentative recovery form the labor market, it appears likely that the US will stay out of recession unless Europe blows up. The greenback behaved as it usually does in a risk averse, deleveraging environment, rising against every G10 currency save the Yen.